A Slow Evolution in Indexing for Sovereign Debt ETFs

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A prominent figure in the exchange traded fund (ETF) world describes a RAFI fundamental index evolution, which will help achieve greater returns at lower risks. However, there is a caveat. ETF traders will have to see this slow change over the next 10 years.

Olivier Ludwig for IndexUniverse asked Rob Arnott, founder of Research Affiliates and the Father of Fundamental Indexing, about his thoughts on the future of ETFs. Arnott sees that indexes in the bond ETF market will start to shift more toward weighting bonds according to an issuer’s capacity to service debt instead of the current weighting to the size of the issuer’s debt. [ETFs and Indexing: Beyond Market-Cap Weighting.]

Emerging markets account for 37% of global GDP but they only make up 10% of world sovereign bond debt, says Arnott. RAFI for bonds shows investors that one is better off weighting according to capacity to service instead of weighting according to the size of the debt. The logic behind this is that developed countries are heavily debt ridden while emerging markets are not, but emerging markets are unfairly attached with a higher risk premium.

Arnott also describes a RAFI for sovereign debt, which weights the country according to the size of the economy, the size of the country and size of its debt-service capacity. Simple intuition would dictate that lending to countries with little debt is safe while those with heavy debt burdens are left with less. [Sovereign Debt ETFs: A Good Bet After Europe's Bailout?]

Some worry about the notion that the introduction of bond ETFs are helping to price bonds, but Arnott believes that the price discovery mechanism in ETFs help the overall market, along with providing greater liquidity and allowing more investors to control their investments.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.